Tuesday, 20 May 2014

Central Banks – false illusion of power

The Bank of England
shows how little central banks can do with their limited resources

Everyone looks to central banks as the custodians of the
economy. Once upon a time, central banks
were regarded as having almost mythical powers to control the forces of the
economy. However, this fairy tale was
shattered by the global financial crisis and central banks have since been trying
to regain their previous status as economic titans. Central banks have fought back with extra
powers such as quantitative easing which have helped bolster their popularity. In contrast, the trouble that the Bank of
England is having in dealing with the conflicting problems of a fragile
recovery and a booming housing market shows central banks at their most impotent.

The myth and the
reality

Much of what central banks do relies on creating a belief in
their resolve and ability to call on seemingly unlimited resources. Chronic inflation in the 1970s was reined in
by central banks flexing their muscles and inflation has stayed low ever since. Even in the throes of a crisis, the European
Central Bank kept the Eurozone together merely by proclaiming that it was
willing to do “whatever it takes” to do so.

With the power to print money, central banks have the
godlike ability to create something out of thin air. It is often only the ideas of economics that
keep central banks from unleashing the full force of their powers. The ability to summon money from the ether is
of limited use when most economists are scared of rising inflation following an
increase in the supply of money.
Economics has also restricted central banks to operating only in a small
arena, which reduces their capacity to act as a power for good.

One example of this is quantitative easing which helped ease
the pain over the downturn but came with side effects.
The purchases of bonds through quantitative easing helped to shore up
the financial markets but did little to alleviate a chronic shortage of demand
in the actual economy. A slightly
different way of using quantitative easing could have had more punch with less mess
but also came with the possibility of some inflation.

Like something from
Greek tragedy

The Bank of England operates in this world of possibilities,
but with only limited options. It has
made use of what was available (low interest rates and quantitative easing) but
the economic recovery has struggled to gain much traction even after five
years. Yet, the consequences of its
policies have shown up as a housing market boom at a time when the Bank of
England still has its hands full nursing the economy.

One thing that the Bank of England is missing is a bit of
help from the government. Not only is
the government dragging down the economy with its austerity measures, but it is
creating problems
with policies such as Help to Buy which stoke up the property market just as
the central bank is praying for it to cool down. For all of their potential power, central
banks still have to steer clear of politics putting any criticism of government
policy out of bounds. The government
with all of its populist tendencies still trumps an institution established to
look out for the long term health of the economy.

Instead, the Bank of England and its governor, Mark Carney,
have tried to use the media to communicate their concerns about the property
market. However, this is having little
effect as the Bank of England can be ignored since there are few actions it
could actually take to back up its words.
Its main weapon would be higher interest rates but the economic recovery is seen as not yet being strong enough. It
would be a shame to see the Bank of England fall from grace battling a wayward
government and a run-away property market but it will take a heroic feat to
stop that happening.